CHAPTER 18

1. Apply horizontal and vertical analysis to financial statements.

Analyzing financial statements involves evaluating three characteristics: a company’s liquidity,
profitability, and solvency.
A short-term creditor, such as a bank, is primarily interested in liquidity—the ability of the
borrower to pay obligations when they come due. The liquidity of the borrower is extremely
important in evaluating the safety of a loan.
A long-term creditor, such as a bondholder, looks to profitability and solvency measures that
indicate the company’s ability to survive over a long period of time. Long-term creditors
consider such measures as the amount of debt in the company’s capital structure and its ability to
meet interest payments.
Similarly, stockholders look at the profitability and solvency of the company. They want to
assess the likelihood of dividends and the growth potential of the stock.
Need for Comparative Analysis
1. Intracompany basis: Comparisons within a company are often useful to detect changes
in financial relationships and significant trends.

2. Industry averages: Comparisons with industry averages provide information about a

company’s relative position within the industry.
3. Intercompany basis: Comparisons with other companies provide insight into a
company’s competitive position.

Tools of Analysis
We use various tools to evaluate the significance of financial statement data. Three
commonly used tools are as follows.
• Horizontal analysis evaluates a series of financial statement data over a period of time.
• Vertical analysis evaluates financial statement data by expressing each item in a financial
statement as a percentage of a base amount.
• Ratio analysis expresses the relationship among selected items of financial statement data.
Horizontal analysis is used primarily in intracompany comparisons.
Vertical analysis is used in both intra- and intercompany comparisons.
Ratio analysis is used in all three types of comparisons.
Horizontal Analysis
Horizontal analysis, also called trend analysis, is a technique for evaluating a series of
financial statement data over a period of time.
Its purpose is to determine the increase or decrease that has taken place.
This change may be expressed as either an amount or a percentage.
Formula for horizontal analysis of changes since base period

Formula for horizontal analysis of current year in relation to base year

Horizontal analysis of balance sheets

Horizontal analysis of income statements

Horizontal analysis of retained earnings statements

Vertical Analysis
Vertical analysis, also called common-size analysis, is a technique that expresses each financial
statement item as a percentage of a base amount.
On a balance sheet, we might say that current assets are 22% of total assets—total assets being
the base amount. Or on an income statement, we might say that selling expenses are 16% of net
sales—net sales being the base amount.
BALANCE SHEET
The base for the asset items is total assets. The base for the liability and stockholders’ equity
items is total liabilities and stockholders’ equity.
The formula for calculating these balance sheet percentages is: Each item on B/S / % Total assets
INCOME STATEMENT
 2. Analyze a company’s performance using ratio analysis.
Ratio analysis expresses the relationship among selected items of financial statement data.
A ratio expresses the mathematical relationship between one quantity and another. The
relationship is expressed in terms of either a percentage, a rate, or a simple proportion.
Percentage: Current assets are 347% of current liabilities.
Rate: Current assets are 3.47 times current liabilities.
Proportion: The relationship of current assets to liabilities is 3.47:1.
 3. Apply the concept of sustainable income.
Sustainable income is, therefore, the most likely level of income to be obtained by a company
in the future.
Sustainable income differs from actual net income by the amount of unusual revenues,
expenses, gains, and losses included in the current year’s income.
An income statement provides information on sustainable income by separating operating
transactions from nonoperating transactions. This statement also highlights intermediate
components of income such as income from operations, income before income taxes, and income
from continuing operations.
Discontinued Operations
Discontinued operations refers to the disposal of a significant component of a business, such as
the elimination of a major class of customers, or an entire activity.
Following the disposal of a significant component, the company should report on its statement
both income from continuing operations and income (or loss) from discontinued operations.
The income (loss) from discontinued operations consists of two parts: the income (loss)
from operations and the gain (loss) on disposal of the component.

Other Comprehensive Income

Most revenues, expenses, gains, and losses are included in net income. However, certain gains
and losses bypass net income. Instead, companies record these items as direct adjustments to
stockholders’ equity.
ILLUSTRATION OF OTHER COMPREHENSIVE INCOME
A trading security is bought and held primarily for sale in the near term to generate income
on short-term price differences. Companies report unrealized losses on trading securities in the
“Other expenses and losses” section of the income statement. The rationale: It is likely that the
company will realize the unrealized loss (or an unrealized gain), so the company should
report the loss (gain) as part of net income.
Available-for-sale securities are held with the intent of selling them sometime in the future.
Companies do not include unrealized gains or losses on available-for-sale securities in net
income. Instead, they report them as part of “Other comprehensive income.” Other
comprehensive income is not included in net income. It bypasses net income and is recorded
as a direct adjustment to stockholders’ equity.
FORMAT

Companies also report the unrealized loss on available-for-sale securities as a separate

component of stockholders’ equity.

COMPLETE STATEMENT OF COMPREHENSIVE INCOME